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This Week In Alarming Papers About Collateral

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I am always afraid to wade into the world of collateral and repo and rehyp and whatnot because it is big and complicated and smarter people than I splash around in it, but this week has had some good stuff so let's talk about it for a bit. NBER's weekly dump of things you could read if you wanted to yielded up a trove of Gary Gorton, including a Gorton-Lewellen-Metrick paper about how much of our economy has historically been composed of safe assets (answer: 33%! weird) and a heavy-sledding but apparently good Gorton-Ordonez paper modelling financial crises as the effect of people deciding that "information insensitive" collateral should be information sensitive. There's also an interesting paper by Krishnamurthy, Nagel and Orlov (let's go with K-N-O) that maybe illuminates that point. It's called "Sizing Up Repo," and if you're not already into this sort of thing, here is a picture describing exactly how clear the rest of this will be:

Heheheh no really. Anyway, the basic gist of this whole realm of literature goes something loosely like this:
1. Humans put money in banks and banks lend this money to companies and fulfill their basic role of financial intermediation.
2. Also, there's a whole lot of other stuff that isn't "banks" but serves some of the same role, that is, intermediate between human savers and companies that need money.
3. That other stuff is looooooooosely "shadow banking," and a lot of it consists of humans - and corporations, endowments, etc. - putting their money into things - like money market funds, mutual funds, etc. - that then lend money to each other or the banking system via short-term money-like instruments that sort of fill functions similar to bank deposits. A lot of these instruments take the form of very short-dated loans backed by financial instrument collateral, roughly speaking "repo."
4. Something broke in that system and helped cause the financial crisis.

The K-N-O paper is a contribution in that vein, and here is the point where I felt like I could stop reading because I had learned something:

Our results also highlight that to understand the role of repo during the crisis, it is important to distinguish between funding conditions that dealer banks face when they borrow cash from MMF [money market mutual fund] and SL [securities lenders, i.e. asset managers who lend securities and reinvest the cash in money market instruments] via (largely tri-party) repo from the funding terms that dealer banks offer when they lend via (largely bilateral) repo to other dealers or hedge funds. [An earlier paper by] Gorton and Metrick document that haircuts in the interbank market rose dramatically in the crisis, while we find much smaller increases in the MMF-to-dealer bank haircuts. Gorton and Metrick report the largest haircuts for private-label ABS securities, for which we observe no transactions between MMF and dealer banks at the height of the crisis.

To reconcile these findings, it is important to keep in mind that dealer banks are more capable than an MMF of disposing collateral in the event of a default by a repo counterparty and of assessing the risk of counterparty. In contrast, our data suggest that MMF stop lending when collateral becomes too illiquid or risky. The picture that emerges from our analysis is that MMF and SL are analogous to "bank depositors" who place their funds with dealer banks through the tri-party repo market. These dealer banks in turn are like informed lenders who then pass these funds on to hedge funds and others dealers through the bilateral repo market. Our data suggest that the "depositors" pulled back from dealer banks during the crisis. The Gorton and Metrick findings show that the dealer banks pulled back much more dramatically in their interbank lending to other dealers and their credit extension to hedge funds. Overall, the picture therefore looks less like the analogue of a traditional bank run by depositors and more like a credit-crunch in which dealers acted defensively given their own capital and liquidity problems, raising credit terms to their borrowers. These higher credit terms are manifest in the higher haircuts observed by Gorton and Metrick.

So, sure, shadow banking contracted and that caused some bank-run-type effects, but the considerably bigger effect was caused not by money market funds fleeing the market but by primary dealers consciously cutting back on credit extension to hedge funds and each other. As the authors find, "Primary Dealer repo outstanding contracted by 40% between 2008Q2 and 2009Q2, while total MMF and SL repo contracted by only 27% over the same time period, starting from a much smaller dollar number, and with almost all of the contraction driven by SL repo. Thus, the total amount of repo (and re-hypothecation) along the intermediation chain contracted more than the credit extended by non-bank repo lenders." So the 2008 funding crisis was not just about repo lenders cutting back their funding of the banking system; it was more so about the banking system cutting back funding of end-user borrowers like hedge funds.

That actually seems like a neat result and is news to me. For one thing, it lets you wear your Jamie-Dimon-killed-every-failed-financial-institution tinfoil hat proudly. A thing you can think, based on this, is that places like Bear and Lehman and MF Global were brought down not by uncoordinated runs on banks by binary on/off investors, like money market funds, who will keep money with them until they pass some vague perceived-risk threshold and will then flee, but instead by thoughtful/over-conservative/evil risk-management decisions by a handful of big dealer banks who monitor credit quality quite closely. Is that good? Maybe not - maybe the banks did not in fact do much credit monitoring and cut back on credit due solely to their own capital and liquidity problems. (But, remember, they cut back their output of liquidity by more than their inputs were cut back.) Maybe they cut back on credit just out of evilness / desire to buy wounded competitors cheap / desire to mess with Jon Corzine. But maybe it's a good thing - maybe there was some monitoring of credit quality and decisionmaking based on that; maybe the intermediation of repo funding through banks imposed more discipline on borrowers than would informationally-insensitive triparty repo funding.

More broadly, this paints a more subtle picture of the meaning of "information insensitive" debt. On this view, there is lots of demand for collateral that is just demand for on/off "safe collateral," from people like money market funds and stuff. But there is even more demand for collateral from banks, or primary dealers, who are (we hope!) not so naive as to think that some things are just plain "safe," and are sensitive to things like the quality of the collateral and the quality of the underlying borrower. And indeed much of the chain goes from insensitive funding sources (MMFs etc.) through banks (who do a lot of triparty repo borrowing) and thence to ultimate borrowers (hedge funds etc.) who do a lot of bilateral funding from banks. Thus even in our shadow-banking-stuffed world, the banks do a lot of their traditional role of evaluating credit quality. Or in other words the movement of short-dated money-like funding to markets rather than regular old bank lending has not fully disintermediated banks from their traditional role.

In maybe related news, and the last "things to think about collateral" topic for today I promise, Manmohan Singh, an IMF economist who's one of the leaders in this field and who we've mentioned before, had another cool op-ed thing at VoxEU this weekend abstracted thusly:

Regulators around the world are looking to regulate derivatives. This column argues, however, that current proposals for centralised counterparties are misguided. Instead of reducing risk in the notorious over-the-counter derivatives markets, they may simply shift it around. It calls for a tax on the derivative liabilities of large banks to tackle the problem at its source.

It's a neat little paper. The crux of the argument goes like this:

A single, central counterparty with an adequate, multicurrency, central-bank liquidity backstop that would be well regulated and spans the broadest range of derivatives would have been an ideal “first-best” solution. ... Recent developments suggest a significant departure from the envisaged first-best solution. In fact, there will be a plethora of central counterparties since many jurisdictions, such as Australia, Canada, etc., do not want to lose oversight of their local currency derivative products to an offshore central counterparty. ... We are not moving the status quo of 10-15 large banks (or “pockets” of risk) to one global “pocket” (which would maximise netting); we are moving towards something like 20-30 “pockets” of risk that include large banks and CCPs. In short, the bottom line is that the world may be moving part way to the first-best solution. Basic economics tells us that such partial reform can make things worse.

You can read how it makes things worse - mainly by cutting down on the use of collateral and costing banks funding, which maybe you're okay with, I dunno. Also by increasing certain systemic risks because the clearinghouse in, whatever, Australia will be riskier than, whatever, JPMorgan. And you can read about his proposed solution, which is to keep OTC derivatives OTC but to tax banks to make them collateralize them better.

An implicit premise here is something like "concentrating global financial risk into a dozen too-big-to-fail banks is better than concentrating global financial risk into two dozen too-big-to-fail clearinghouses." Is it? I don't know. But I feel like the K-N-O paper can give you an interesting way to think about that. In particular if you think that banks irrationally multiply the effect of losses in confidence, then clearinghouses will probably be less irrational and so do a better job. But if you think that, even in an age of instantaneous trading of mark-to-market contracts, banking institutions still provide some value in evaluating credit quality, then that's another reason to worry about shifting systemic risks to market clearing mechanisms.

Krishnamurthy, Nagel & Orlov: Sizing Up Repo [NBER]

The puzzling, perpetual constancy of safe asset demand [FTAV]

The fallacy of moving the over-the-counter derivatives market to central counterparties [VoxEU]